Under the terms of a European competition ruling, Lloyds must sell or dispose of the branches by the end of November 2013 as part of a package linked to the state aid provided at the time of Lloyds' takeover of HBOS.

It is understood regulators have questioned the amount of capital in the group's banking business, and whether it was sufficient once taking into account its soon-to-be enlarged banking book.

The decision to pull out was made by a meeting of the Co-op board, thought to have been held at the end of last week.

However Lloyds is believed to have only been informed of the decision late on Tuesday.

Lloyds' chief executive Antonio Horta-Osario said in a statement this morning the bank was "disappointed" the Co-op was unable to complete the deal, but added that it was "well advanced" in its plans to bring the Verde business to the high street under the TSB brand.

In a separate statement this morning, the Co-op said its decision to pull-out reflected "the impact of the current economic environment, the worsened outlook for economic growth and the increasing regulatory requirements on the financial services sector in general".

Peter Marks, group chief executive of the mutual, added that the transaction would not deliver "a suitable return for its members within a reasonable timeframe and with an acceptable level of risk".

It follows months of speculation surrounding the Co-op's capital position, and comes four weeks after the mutual posted a £599m loss for the year to January 5.

Lloyds confirmed it will now pursue an initial public offering of the business under the TSB brand, which was being sold to the Co-op as part of the deal.

The stand-alone bank will have 7.5pc of the UK branch network and 5pc of UK current accounts. Lloyds said the bank would be extricated from its own business this summer, at which time the TSB brand will become visible on the high street.

Lloyds was providing the management for the tie-up with the Co-op, as well as the technology platform and the financing.

The Co-op was due to pay an initial £350m, with a further £400m based on performance factors.

It is thought a number of the parties currently vying to buy the 300-odd branch business being sold by Royal Bank of Scotland could also be interested in the Verde assets.